Mark Benbow, high yield portfolio manager at Aegon AM, believes company fundamentals are strong, and therefore unlikely to cause widespread defaults, despite rising fears of a recession which has sent a shockwave through markets.
“When the next recession materialises, defaults will inevitably increase. As in all cycles, the extent of defaults will be dependent on the severity of the economic downturn and the triggers that cause the recession,” says Benbow.
“A confluence of macro risks has led to rising recession fears. From persistently high inflation, hawkish central bank actions and ongoing cost pressures to weakening consumer demand, earnings compression and tightening credit concerns, there are many factors that could contribute to an economic slowdown or recession.
“In prior recessions, certain sectors or industries were facing financial challenges and an abrupt shock to revenue or demand created broad-based credit deterioration. In the current environment, we do not see broad-based credit deterioration across any single sector at this point.
“Certain sectors and industries are more prone to cost pressures and potential weakness than others, however, the stressed or distressed situations that are emerging tend to be driven by idiosyncratic factors.”
Benbow believes that bankruptcies will be limited, with default activity leading to more liability management or rescue financing instead. Companies with prolonged margin pressure thanks to labour and supply chain issues could be most at risk.
“When default activity does increase, this will likely manifest itself via more liability management or rescue financing type of situations versus outright bankruptcies. Sponsor-owned companies are more prone to liquidity shortfalls as earnings may take longer to rebound vis-à-vis their debt loads stemming from leveraged buyouts.
“We are watching companies that are experiencing substantive and prolonged margin pressure due to labour or supply chain issues. Additionally, we are cautious on issuers that are facing secular headwinds due to technological advancements.
“By sector, we are closely monitoring companies within retail, health care, technology, autos, building materials as well as aerospace and defence.”
In terms of outlook, Benbow concedes that companies are facing increased macroeconomic headwinds. But on balance, high yield companies are in a good position to weather the storm, relative to prior recessions he says.
“Companies are facing a number of macro headwinds and ongoing margin pressures. While this environment can be challenging, we think many high yield companies are well-positioned to navigate an economic slowdown given low leverage, healthy balance sheets and few near-term maturities.
“Inflation and other pressures are squeezing margins and could erode earnings. However, many companies have various levers they can pull to navigate these situations in an effort to meet their debt obligations and avoid a default situation.
“In addition, most performing companies reliant on levered credit improved their liquidity runway coming out of the Covid-19 crisis and there is not an imminent maturity wall looming. Stressed companies are still able to access capital markets, albeit at higher cost of capital.”
Benbow sees default rates rising “modestly” this year, but that this is from a historically low level. He sees default levels remaining below 2% for the rest of 2022.
“Although high yield company fundamentals are in a relatively healthy position, we expect the default rate to modestly increase in 2022 as a result of idiosyncratic factors.
“While defaults are trending upward, it is important to remember that defaults are starting from historically low levels that are not sustainable throughout a cycle. As a result, while defaults are starting to increase, we expect the solid fundamental backdrop to help keep defaults below 2% in 2022 and below historical averages throughout 2023.”
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